Real Gross Domestic Product (GDP) during the third quarter (July, August, and September) of 2005 increased at an annual rate of 4.3 percent. This is the second estimate of the rate of change in the third quarter and is higher than the first estimate in October.

Please do the following multiple choice activity:

This compares to annual rates of 3.8 and 3.3 percent in each of the first two quarters of 2005. For the entire 2004 year, real GDP increased at a rate of 4.2 percent. Annual growth rates in 2001, 2002, and 2003 were .8, 1.6, and 2.7 percent.

Definition of Gross Domestic Product

Gross Domestic Product (GDP) is one measure of economic activity, the total amount of goods and services produced in the United States in a year. It is calculated by adding together the market values of all of the final goods and services produced in a year.

It is a gross measurement because it includes the total amount of goods and services produced, some of which are simply replacing goods that have depreciated or have worn out.

It is domestic production because it includes only goods and services produced within the U.S.

It measures current production because it includes only what was produced during the year.

It is a measurement of the final goods produced because it does not include the value of a good when sold by a producer, again when sold by the distributor, and once more when sold by the retailer to the final customer. We count only the final sale.

Changes in GDP from one year to the next reflect changes in the output of goods and services and changes in their prices. To provide a better understanding of what actually is occurring in the economy, real GDP is also calculated. In fact, these changes are more meaningful, as the changes in real GDP show what has actually happened to the quantities of goods and services, independent of changes in prices.

Details of the Third-Quarter Changes in Real GDP

Real GDP increased at an annual rate of 4.3 percent, a significantly higher rate of growth than in either the first or second quarters. The major contributors to the increase in real GDP in the third quarter were increases in personal consumption, investment in housing and equipment and software, and an increase in national defense spending. Those increases were partially offset by a decrease in inventory investment. Imports also increased.

Figure 1 shows quarterly changes since 1990. The 1990-91 and the 2001 recessions can be seen in the decreases in real GDP.

Figure 2 shows annual changes over a longer period of time. Here you can also see the recessions in the middle of the 1970s and the beginning of the 1980s. Figure 2 also shows the average annual rate of growth of 3.1 percent since 1970.

Why are Changes in Real Gross Domestic Product Important?

The measurement of the production of goods and services produced each year permits us to evaluate our monetary and fiscal policies, our investment and saving patterns, the quality of our technological advances, and our material well-being. Changes in real GDP per capita provide our best measures of changes in our material standards of living.

While rates of inflation and unemployment and changes in our income distribution provide us additional measures of the successes and weaknesses of our economy, none is a more important indicator of our economy's health than rates of change in real GDP.

Changes in real GDP are discussed in the press and on the nightly news after every monthly announcement of the latest quarter's data or revision. This current increase in real GDP will be discussed in news reports as a positive sign of the strength of the current economy.

Real GDP trends are prominently included in discussions of potential slowdowns and economic booms. They are featured in many discussions of trends in stock prices. Economic commentators use decreases in real GDP as indicators of recessions. The most popular (although inaccurate) definition of a recession is at least two consecutive quarters of declining real GDP.

Prices

The price index for GDP increased at a rate of 3.0 percent during the third quarter of 2005, compared to an increase of 2.6 percent during the second quarter of 2005. It increased at an annual rate of 2.6 percent for all of 2004.

Much of this increase is due to increases in prices of energy.

Please do the following multiple choice activity:

GDP, Productivity, and Unemployment

A major factor in the long-term growth in the American economy is continued improvement in productivity. (See the most recent Productivity case study). Productivity increased at an annual rate of 4.7 percent in the third quarter of 2005. Businesses are able to gain more output from the same number of workers. This is actually faster than the growth in real GDP, but is from a slightly different sample. But if real GDP increases 4.3 percent and productivity rises 4.7 percent, the number of hours worked (and perhaps employment) declined.

The Federal Reserve has stated in recent releases that continued productivity growth is a key component in the continued growth in the American economy. Businesses are able to expand production more rapidly than the growth in employment and thus real GDP per capita can increase.

Please answer the following multiple choice question:

A Hint about News Reports

Many news reports simply use "gross domestic product" as a term to describe this announcement. The actual announcement focuses on the real gross domestic product, and that is the meaningful part of the report. In addition, newspapers will often refer to the rate of growth during the most recent quarter and will not always refer to the fact that it is reported at annual rates of change. This is contrasted to the reports of the consumer price index, which are reported at actual percentage changes in the index for a single month, and not at annual rates.

Explanations of GDP and its Components

Gross domestic product consists of goods and services produced for consumption, for investment, for government, and for export. The GDP accounts are broken down into consumption spending, investment spending, government spending, and spending on U.S. exports. To arrive at the amount actually produced (that is, GDP) our spending on imports is subtracted from those other amounts of spending. Thus,

Consumption spending consists of consumer spending on goods and services. It is often divided into spending on durable goods, non-durable goods, and services. These purchases currently account for 70 percent of GDP.

Durable goods are items such as cars, furniture, and appliances, which are used for several years.

Non-durable goods are items such as food, clothing, and disposable products, which are used for only a short time period.

Services include rent paid on apartments (or estimated values for owner-occupied housing), airplane tickets, legal and medical advice or treatment, electricity and other utilities. Services are the fastest growing part of consumption spending.

Non-residential fixed investment is the creation of tools and equipment to use in the production of other goods and services. Examples are the building of factories, the production of new machines, and the manufacturing of computers for business use.

Residential investment is the building of a new homes or apartments.

Inventory changes consist of changes in the level of stocks of goods necessary for production and finished goods ready to be sold.

Government spending consists of federal, state, and local government spending on goods and services such as research, roads, defense, schools, and police and fire departments. This spending (19 percent) does not include transfer payments such as Social Security, unemployment compensation, and welfare payments, which do not represent production of goods and services. Federal defense spending now accounts for approximately 5 percent of GDP. State and local spending on goods and services accounts for 12 percent of GDP, while federal spending is 7 percent of GDP.

Exports are goods and services produced in the U.S. and purchased by foreigners – currently about 10 percent of GDP.

Imports are items produced by foreigners and purchased by U.S. consumers are equal to 15 percent of GDP. Net exports (exports minus imports) are negative and are about 5 percent of the GDP.

GDP as a Measure of Well-Being

GDP fails to account for many forms of production that improve a person’s well being. For example, if you make a meal at home, the labor is not included. However, if you were to go out to a restaurant and consume that same meal, the labor is included in GDP. Unpaid work at home or for a friend and volunteer work is not included and thus GDP does not reflect production of all we produce.

External effects of production, such as pollution, are not subtracted from the value of GDP. Although two countries may have similar GDP growth rates, one country may have significantly cleaner water and air, and therefore is truly better off than the other country. If as economic growth accelerates, producers begin to employ production techniques that create more pollution, the effects of the growth are overstated.

GDP includes police protection, new prisons, and national defense as goods and services. It is not always clear that if we have to devote increased resources for such purposes that we are better off as a result.

GDP includes the effects of price changes. An increase in GDP due solely to inflation does not signal an improvement in living standards. Real GDP is a better measure. Nor does GDP reflect population growth. Changes in the income distribution are not measured. It is also difficult to compare rates of growth for different countries, as countries use different means of estimating income and price levels in their economy.

There are a variety of other weaknesses and inaccuracies, but GDP accounting is the best that we have. Real GDP does provide sound signals as to the direction of change of a selected large part of what we produce each year. Government statisticians and academics are constantly working to improve its accuracy and its ability to reflect our well being.

Revisions in GDP Announcements

Real GDP for each quarter is announced three times. The month following the end of the quarter is described as the advance real GDP; the second announcement or revision is described as the preliminary announcement; and the third month is the final. While labeled as the final version, even it will eventually be revised after the final data for the year are published. Since 1978, the advance estimates of the rate of growth in real GDP have been revised an average of 0.5 percent in the next month's preliminary estimate. The preliminary estimates have been revised by an average of an additional 0.3 percent.]

Revisions in inventory investment and the international trade data are often the causes of changes in the GDP figures. Those data for the last month of the quarter are not available when the advance estimate of GDP is announced.